What Happened in 2008? by Paul Cottrell

The financial crisis of 2008 was the worst financial crisis since the Great Depression of the 1930’s.  Many books have been written on why the 2008 crisis happened.  Irwin (2013) stated that central bankers knew that the housing bubble was a serious problem, but the central banks’ policy makers failed to have the imagination to understand the confluence of events that could magnify and bring down the whole global economy.  In Geithner (2014), lack of firepower to bailout institutions in the banking sector was lacking in the early stages for the crisis.  In terms of risk models, in Deman(2011), quant models are based on assumptions and those assumptions can become invalid over time—leading to inappropriate pricing of assets and risk assessments.  Others have suggested that over indebtedness in the public and private sector was the cause of the decline of developed economies (Ferguson, 2013).  The point of this book is not to comprehensively explain the crisis of 2008, but to suggest that economic systems evolve and emergent properties result, albeit some good and some bad properties.  It is fair to say that the lack of imagination and the true risk of contagion are good starting points.  We need better tools for assessing risk in the financial system, whereby we can evaluate endogenous and exogenous risk.

The financial crisis of 2008 resulted in the threat of total global financial collapse, whereby even the assumptions of free market capitalism and democracy were seriously questioned.  This was a dangerous time and still is as of this writing.  For example, European countries are still floundering economically, especially in the peripheral nations of the European Union.  European countries tied to the Euro currency no longer have the ability to adjust their own monetary policy, and in that respect have lost economic sovereignty and self–determination.  The problems are not just in Europe.  There seems to be a global trend of a zero interest rate policy in developed nations, which is new to central bankers’ experiences.  Is it possible that monetary policy that created the great moderation has led to new monetary dynamics that the central banks will have a hard time modulating.  For example, when the United States of America starts to eliminate quantitative easing and the economy starts to wobble, will the Federal Reserve reverse their tightening policy?  It is not at all clear that the central banks are in control of zero interest rate policy epochs.  For example, in an inflationary situation the central banks can just raise rates, which they have a lot of room to do so—but might led to further erosion of aggregate demand.  In extreme increases in aggregate demand the central banks can modulate the economy.  This is not the case in a deflationary condition where the rates are already zero bound.  What can the central banks do if the aggregate demand continues to erode with zero bound rates?  The only thing that the central bank can do is severe asset purchases of all kinds—even ketchup.

The financial crisis also involved massive financial bailouts of banks, larger corporations, and citizens.  For example—even though Lehman was not bailed out—General Motor, AIG, Chrysler Motors, and many banking firms were.  Even with the bailouts, the money markets were not functions properly and a severe recession ensued.  In the United States quantitative easing was initiated by purchasing many different asset backed securities but other countries were forced into austerity policies, especially in the European region—creating more financial harm than good.  This austerity was promoted by Germany and the IMF when countries, such as Greece, were in trouble of defaulting on their sovereign bonds. At the time of this writing the ECB is starting to adopt a different stance and invoking a lender-of-last-resort policy regime and asset purchase buyer.